Futures trading is a dynamic and potentially lucrative financial process that allows traders to speculate on the future price movements of various assets, from commodities like coffee to financial instruments like stock indices and currencies.
In essence, the futures market allows people to come together to predict if the prices of things like commodities, currencies, or market indexes will go up or down in the future. That’s where both hedgers and speculators meet.
It is expedient to note that the world of futures trading can be puzzling and intimidating, with its various terms and strategies. But it offers a way to protect your investments or potentially make big profits. To succeed, you need to understand how these financial tools work.
Future contracts can be used by investors, speculators, and other financial players. In this guide, we’ll delve into the world of futures trading, providing you with the knowledge and tools you need to start trading confidently.
Futures are contracts to buy or sell assets at a future date upon an agreed price. Participants in this market are mostly consumers or commercial or commodities producers.
Notably, futures contracts, often referred to as “futures,” find their home on futures exchanges and you’ll need a brokerage account approved for futures trading to participate.
These exchanges serve as a platform where investors have the opportunity to engage in the trading of futures contracts. In these contracts, one party commits to purchasing a specific quantity of securities or a commodity, with an agreed-upon delivery date, while the other party undertakes the responsibility to supply said assets.
Moreso, when a futures contract expires, the buyer is obliged to purchase and take possession of the underlying asset, while the seller must provide and deliver that asset, making it distinct from options that can simply become worthless at expiration.
Futures are used to hedge the movement in the price of an asset to prevent losses from unfavourable price changes. Engaging in hedging gives one a position that is opposite to the one held with the underlying asset.
Futures are also called futures contracts, they are traded on a futures exchange at a contract’s price at the end of each trading session. They give traders room to lock in the price of the underlying asset and these contracts have expiry dates and set prices that are agreed upon ahead.
Future contracts specify different contract parameters which include:
- futures contract currency (quotation for the contract);
- futures contract currency unit (contract denomination);
- goods quantity to be delivered/covered under the contract;
- trade settlement agreement;
- the grade or quality of the commodity considered;
- unit of measurement.
Types of Futures
Futures trading offers traders multiple kinds of contracts to trade with, some of which will be explained below.
- Commodity futures. This contract involves an agreement to buy or sell an already determined amount of commodity (for example, grains such as wheat, precious metals such as gold, and energy such as crude oil, to name a few) at an agreed price and date in the future. Individuals can have access to commodities futures markets through a managed futures account made available through commodity Trading Advisors (CTAs).
- Index futures. In this type of contract, a future product may use a variety of multipliers to determine the trading price of the futures contract. This futures contract is common with investors (i.e. e-mini S&P 509 future contracts).
- Currency futures. This involves looking to make money through movement in rates of foreign exchange. A strategy adopted by traders in this contract is scalping, scalpers take short-term profit off increments in changes in currency values. A repetition of this accumulates profit over time which gives a huge profit on adding up accumulated profits together. This strategy calls for discipline so as to continually make small profits and avoid huge losses. This future is not the same as spot forex trading which is common among individual traders. Examples of currency futures include the Euro, British pound, Canadian dollars, CME Bitcoin, New Zealand dollar, etc.
- Precious metals futures. This type of futures contract provides exposure to the price of metals that companies rely on for their productions. Examples of these metals are gold, silver, copper, platinum, and palladium.
- Energy futures. This contract provides exposure to the price of energy products commonly used by companies, individuals and governments for the purpose of consumption. Examples of these futures are crude oil, natural gas, Heating oil, gasoline, Ethanol, etc.
- Livestock futures. This contract makes provision for the exposure to the prices of animals that are used in supplying, processing, and distributing products derived from meats. Examples are live cattle, feeder cattle, and lean dogs.
Uses of Futures
Futures are often used by people to get things they need, while some use them like a betting game to make money. Regardless, the uses of futures can be primarily classified into the following:
- Hedging with futures. Irrespective of the intention, futures contracts are used for hedging purposes by investors or companies, this helps to manage the risk in future prices of the underlying asset or commodity on their investment portfolio.
- Speculating with futures. Futures contracts are liquid and they can be purchased or sold up to the time of expiration. This feature enables traders to buy or sell futures for expression of their opinions and make a profit from the market direction for an asset or commodity and before expiration, traders can buy or sell offsetting futures contracts.
Future trading is easy to start with, the initial step is to open an account with a broker who then gives you a quote and a chart while some provide research and advice.
One of the advantages of futures contracts among many others is the ability of traders to trade with large quantities of commodities, this is because the requirement is just to make a deposit of an initial margin with the broker.
As part of its primary purpose, futures trading offers investors the opportunity to speculate on the future price direction of an underlying asset, thereby enhancing the potential for a positive yield.
Furthermore, futures trading is beneficial to business owners as it allows them to hedge the prices of the raw materials or products they sell, safeguarding themselves against unfavourable price swings.
However, due to the volatility and imprecision in the price movement of commodity markets, the commodity markets are quite risky. This market is majorly dominated by players who deal with risk better. Some of the notable disadvantages of trading futures include the following:
- When companies hedge using futures contracts, they may miss out on favourable price movements, limiting potential profits. While margin trading can amplify gains, it also magnifies losses, making it a double-edged sword that requires careful management.
- The use of leverage in futures trading means investors can potentially lose more than their initial margin deposit, thereby increasing the level of risk involved.
Future contracts are a good way to hedge against the future increment in the price of an asset or commodity. It is quite rewarding yet challenging to trade the various future markets, but thorough research and a good understanding of how future contracts work can lead to successful trading in the futures market.